A bad cliffhanger

The US Congress and President Barack Obama went past their own deadline of midnight on 31 December, but a day later reached a deal on the so-called fiscal cliff. With its vote late on Tuesday night, the House of Representatives joined the Senate in approving legislation that will avert income-tax increases for most Americans and scheduled cuts in defence and other government programmes.

Under the terms of the new deal, income taxes will increase only on those earning more than $400,000 ($450,000 for couples), which is about two per cent of the population. (Other taxes, such as the Social Security payroll taxes that affect all employees, are going up modestly.) Yet while the issue of taxes was resolved, the spending side of the equation was not: the scheduled cuts (referred to as a ‘sequester’) were postponed, and there were no further spending cuts introduced.

After all of the turmoil and angst, this outcome only drags out the fiscal cliff, rather than resolving it. In two months’ time, the issue of spending cuts, along with approval of raising the US federal government’s debt ceiling, will need to be addressed again. It’s like sitting through a bad movie that you couldn’t wait to be over, only to learn there isn’t a conclusion, because they are making a sequel.

The fiscal cliff has its immediate roots in the outcome of the political conflict over raising the debt ceiling in the summer of 2011. Republicans had refused to approve an increase in debt (a move that some have described as being like an unwillingness to pay a credit-card bill after agreeing to use the credit card), as a lever for cuts in spending. The stop-gap agreement was the Budget Control Act of 2011, which called for immediate cuts, as well as a further $1.2 trillion in automatic across-the-board reductions in expenditure on defence and other areas on 2 January 2013, unless that amount of savings was agreed to be found elsewhere. Taxes were also due to go up for all Americans at the New Year, thanks to the expiration of the tax cuts instituted under President George W Bush.

The thought in August 2011 was that the combination of automatic cuts and large tax increases would encourage the two parties to make a ‘grand bargain’. But what it really represented was an abdication of responsibility; unable to compromise, they kicked the can down the road. The August 2011 debt-ceiling talks were an own goal that embarrassed the political class, as credit-rating agency Standard & Poor’s downgraded US debt, and the stock market tanked. By setting a fiscal cliff, officials were just creating the circumstances for a repeat, this time for higher stakes.

The brinkmanship led to much breathless, around-the-clock media coverage, as if the future of the country hung in the balance. But it is important to keep the negotiations in perspective.

On the one hand, the fiscal cliff was never as serious as the doom-mongers made out, certainly in terms of short-term consequences. You have to bear in mind that this was an artificial deadline, imposed by American politicians upon themselves – there was no real crisis, and the deal does not heroically save the day. It is true that a majority of economists predicted that the fiscal implications of cutting spending and raising taxes would tip the economy back into recession. While there is no doubt that a fiscal contraction would have some impact on the economy, there are good grounds to be sceptical. Tax increases would not, in themselves, undermine the economy; for instance, the Clinton administration raised taxes in 1993 and then saw growth follow. And the cuts in spending originally envisioned were relatively small. A strong economy would withstand such fiscal changes; a weak economy would go into recession without them happening.

On the other hand, the deficits and debt situation of the US federal government are more serious in the medium- to long-term than many are willing to face up to. With all the talk about a fiscal cliff and a potential recession in 2013, the more substantial problem of growing debt is being ignored by all participants, including (or especially) President Obama.

David Wessel summarises the longer-term issues raised by the federal budget in his very useful and clear book, Red Ink (2012). The key points he makes include:

• Measures adopted by George W Bush’s administration shifted the US from surplus to deficit, including tax cuts and higher spending on two wars (Iraq and Afghanistan) and Medicare drug benefit. Furthermore, the recession and financial crisis of 2008-2009 added to deficits, due to a) a reduction in tax revenues; b) automatic increases in benefits, such as unemployment benefits; and c) special bailout spending.
• Therefore, President Obama did inherit an economic crisis and deficits. But his administration has added to the deficits – mainly via the nearly $800 billion in stimulus spending in 2009, plus other spending, as well as agreeing to an extension of the Bush tax cuts. The federal government deficit was $6.3 trillion and 45 per cent of GDP when Obama entered the White House in January 2009, and, according to Wessel, it was $10.6 trillion and 70 per cent of GDP in February 2012 (it is now $16.3 trillion, according to the Treasury’s ‘Debt to the Penny’ website).
• Based on the current trajectory, the US government debt will reach 100 per cent of GDP, perhaps within 10 years, maybe sooner. Unlike today’s situation, that level of debt would indeed be at crisis levels.
• About two thirds of spending is on Social Security and healthcare programmes (Medicare and Medicaid), and the costs for both of these are rising and are projected to increase further as the Baby Boomers retire. Therefore, any attempt to reduce spending has to address these programmes. Of these, health is the No.1 cause of growth in spending. (I would add that Obama’s ‘historic’ changes to the health system did not adequately address its rising costs.)
• With large debt, interest costs become larger (and are likely to become larger when interest rates, which have been at historic lows, rise). In 2011, the US government paid more than three times in interest what it spent on all non-defence research and development (R&D) (such as medical research and space exploration).
• However, major cuts in spending and large reductions in interest payments are unlikely to be sufficient to close the gap. Taxes will need to rise (but neither Democrats nor Republicans are countenancing such an increase in the immediate future).

From the point of view of the economy, the main issue is to restore growth. Growth is key to restoring fiscal health, as it will increase revenues and reduce deficits. Projections of high debt levels over the next decade assume modest growth during that period – but we should be more ambitious than that. Despite the parlous state of US finances, even an increase in spending in certain areas that would assist growth – for example in R&D and infrastructure – would be justified, because the net effect would be to lower deficits over time.

However, an appropriate focus on growth does not mean that there is no fiscal problem at all in the US. Keynesian economists such as Paul Krugman are wrong to argue that all government spending has benefits, and that deficits will take care of themselves. Only certain government activities are likely to support productive industry and economic growth; much of the short-term counter-cyclical measures that Keynesians support have only temporary effects. Furthermore, there are spending issues that the US needs to address. There is waste in welfare programmes for individuals (a jaw-dropping one in seven Americans is now on food stamps), as well as for corporations (oil corporations, farms, green ventures, among others). Defence spending does not need to be at historically high levels. And, as mentioned above, the two major structural issues to address are Social Security and Medicare/Medicaid.

Many expressed a sigh of relief that the US did not go over the fiscal cliff this week. But the compromise reached indicates that the two parties are not serious about addressing the real problems: increasing deficits and debt. According to estimates from the Congressional Budget Office, the deal reached on Tuesday will add almost $4 trillion in debt over the next 10 years. Deals like this one only ensure that there will be a bigger reckoning (or cliff) in the future.

Politically, it appears that the Republicans are the big losers, as they voted for a tax increase (which is anathema according to their stated ideology), and did not receive any of their desired spending cuts in return. President Obama had boxed them into a corner, as they did not want to be seen as blocking a reduction in taxes for 98 per cent of Americans.

Conversely, it appears that Obama and the Democrats won, as they were able to get approval for a tax rise on the higher earners and thus fulfil their campaign pledge for ‘tax fairness’. But it’s not that straightforward. By doing a separate deal on taxes alone, the Democrats seem to confirm the broader impression that they have no desire to cut spending and rein in deficits. All Obama has seemed to care about is getting tough on the rich – a move that might make liberals feel good but does hardly anything to bring down debt. Moreover, with this deal they have made the Bush tax cuts permanent for those below the $400,000 income level – the same tax cuts that Democrats have criticised as irresponsible and the root of all fiscal problems for the past decade. Absent an economic boom, it is next to impossible to fund the level of spending that the Democrats desire, especially the retirement provisions of Social Security and Medicare, without broadening the tax base.

In the meantime, we have Fiscal Cliff 2 in March to look forward to. American politicians like to mock the political conflicts and stagnation in countries like Greece and Italy, but the spectacle in the US is now just as unedifying. Setting self-imposed ‘cliffs’, with all the petty bickering and circus-like atmosphere that they entail, is no longer the exception; it’s now standard operating procedure in Washington.

The US faces many objective problems. The subjective shenanigans of the American political class are so bad, so institutionalised, that they have become one of them.

Sean Collins is a writer based in New York. Visit his blog, The American Situation.